Rates and Reality

With this week’s 4.0% GDP number and FOMC meeting statement, concern seems to re-emerge that rates will be headed higher in the near-term.  The Fed has said that they will keep rates low for a “considerable time” once the asset purchased have been eliminated, presumably by the fall off this year.  However, some speculate that there is enough of an improvement in the underlying economy that this move up is coming soon.

It seems premature to say that the 4% initial number in Q2 is a sign of a sustained improvement versus just a bounce back after an incredibly weak Q1, especially with 1.7% of the gain attributed to an inventory build and all of the GDP revisions we have seen of late.  And as Yellen indicated this week in the statement, slack and “underutilization of labor resources” remains.  Not to mention that the geopolitical risks seem to be escalating daily, be it Russia, Argentina, or the Middle East, which will likely hamper global growth further.

So while it is not clear to us that an increase in the interest rates that the Fed controls is on the nearer-term horizon, the Fed will likely move at some point in the next year or two.  But just because the Fed will start to raise rates at some point in the future, that doesn’t mean that we see a big move up in rates across the board, especially the longer maturities (5-30 year Treasuries) versus shorter term rates.  There are other forces at work impacting interest rates.  One of these major forces we are starting to see at emerge, and we expect to become more of a factor in the years to come, is demographics: with an aging populations, we see the demand for yield-based securities accelerating.

As we recently explained in our piece “Of Elephants and Rates,” demographics are destiny and the shift into fixed income from equities is in the beginning innings; rather than the “great rotation” from bonds into stocks as many have argued.  The following chart and quote from Morgan Stanley sum it up nicely.1

Blog 1-30-14a

Published by Morgan Stanley Research on October 8, 2013

Ageing demographics mean regular income, capital preservation and lower volatility are key

We expect that ageing demographics will subdue the strength of this rotation relative to history and will drive convergence between the Retail market and the retirement market. The reduction in equity allocations for the >60 age bracket over the past decade (based on ICI data for the US market) plus the ageing demographic (consultants estimate that within five years nearly 75% of Retail assets will be owned by retirees or those close to retirement) clearly call into question the sustainability and strength of this rotation back into equities. By the end of the decade, the weight of Retail money will be in decumulation phase, as it is in Japan today. We expect that regular income, capital preservation and lower volatility outcomes will be the key focus of this investor group.

Published by Morgan Stanley Research on October 8, 20132

 The bottom line is that the “decumulation” phase is just beginning in most developing countries.  The statement that within 5 years, nearly 75% of retail assets will be owned by those retired or near retirement is almost shocking.  Just how much of the world’s assets are held by retail?  Morgan Stanley recently released a report estimating that approximately $89 trillion of investible assets exist globally and of that about 60% is institutional and 40% retail.3  This translates to approximately $36 trillion in retail assets globally.  Those at retirement age in all countries don’t care about Ibbotson charts or expected returns.  They want tangible income and principal protection.

The demand is also there on the institutional side, with institutional investors now beginning their aggressive move toward LDI (liability driven investing).  LDI is being used not only by insurers, but now by the global defined benefit (“DB”) plan market.  Keep in mind that defined benefit and defined contribution pension plans encompass a significant portion of that 60% of global investible assets that is attributed to institutions.  As equities have soared over the past five years, many of these large DB plans have seen their funding ratios come close to 100%.  Originally, our thinking was that these plan sponsors would continue to “game” pension accounting keeping equity allocations high.  What we mean is that pension accounting involves manipulation; “expected returns” of asset classes based on historical numbers enter into the way DB plans have to fund their liabilities.  Plan sponsors seem to be choosing LDI as a way to “immunize” this liability rather than roll the dice with equities.

LDI is similar to banks running a fully hedged book.  When interest rates rise, the present value of pension plan liabilities fall.  But of course when rates rise, many bond prices fall offsetting the liability gains.  Conversely, when interest rates fall the present value of liabilities rise offset by a gain in bond prices.  Ultimately it is expected that the desire for those running U.S. pension plans to match liabilities will encourage “de-risking,” moving away from equities into the fixed income realm.  We have already seen evidence of this de-risking globally.4

Blog 1-30-14b

Published by Morgan Stanley Research on October 8, 2013

For instance, in the United Kingdom, equity allocations have fallen from 68% to 39% over the last decade, and could ultimately fall as low as 10% for defined benefit plans.5

Blog 1-30-14c

Published by Morgan Stanley Research on October 8, 2013

So the much discussed great rotation from fixed income into equities makes for nice headlines, but the actual numbers look to be far from reality as the demand for fixed income securities heats up globally, including here in the US.

Furthermore, on a yield front, the US looks attractive relative to the rest of the world.  Our 10-year is yielding about the same as those sovereign bonds of the likes of Italy and Spain.  Which would you believe is a more credit-worthy country?  Our rates are more than double those of countries such as German and Japan.6

  Country 10-Year Bond Yield
Switzerland 0.49%
Japan 0.53%
Germany 1.13%
Finland 1.27%
Netherlands 1.32%
Austria 1.37%
Denmark 1.49%
France 1.51%
Belgium 1.52%
Sweden 1.68%
Hong Kong 2.00%
Canada 2.11%
Ireland 2.21%
Norway 2.29%
Singapore 2.46%
United States 2.49%
United Kingdom 2.55%
Spain 2.55%
Italy 2.76%
Israel 2.76%
Portugal 3.68%

Fed policy, as well as supply and demand dynamics all pay into actual interest rates.  As we look forward, demand for bonds and other fixed income asset classes is coming from both the retail and institutional investor and that demand is expected to accelerate as the trend of de-risking away from equities and into fixed income moves firmly into place.  And we are already seeing a strong demand for bonds above and beyond the Fed.  For instance, the bid-to-cover ratio for the longer-term bonds has been nearly 3:1 in 2014.  So while the Fed may ultimately start gradually taking rates up over the next couple years, we expect the demand for Treasuries and other fixed income securities to remain strong, and even accelerate as demographics become more of a factor.  We would expect that this, along with the economic headwinds and global dynamics, will constrain rates going forward.

1 Hamilton, Bruce, Matthew Kelley, Anil Sharma, Andrew Sheets, Anton Heese, and Matthey Hornbach.  “Great Rotation? Probably Not,” Morgan Stanley Blue Paper, Global Asset Managers, October 8, 2013, p. 13.
2 Hamilton, Bruce, Matthew Kelley, Anil Sharma, Andrew Sheets, Anton Heese, and Matthey Hornbach.  “Great Rotation? Probably Not,” Morgan Stanley Blue Paper, Global Asset Managers, October 8, 2013, p. 20.
3 Hamilton, Bruce, Matthew Kelley, Anil Sharma, Andrew Sheets, Anton Heese, and Matthey Hornbach.  “Great Rotation? Probably Not,” Morgan Stanley Blue Paper, Global Asset Managers, October 8, 2013, p. 15.
4 Hamilton, Bruce, Matthew Kelley, Anil Sharma, Andrew Sheets, Anton Heese, and Matthey Hornbach.  “Great Rotation? Probably Not,” Morgan Stanley Blue Paper, Global Asset Managers, October 8, 2013, p. 17.
5 Hamilton, Bruce, Matthew Kelley, Anil Sharma, Andrew Sheets, Anton Heese, and Matthey Hornbach.  “Great Rotation? Probably Not,” Morgan Stanley Blue Paper, Global Asset Managers, October 8, 2013, p. 18.
6 Data sourced from Bloomberg, as of 8/1/14.
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An Inefficient Asset Class

We believe that the best approach to credit investing is to be agnostic on the credit ratings.  This ratings agnosticism is central to our investment philosophy and process.  We believe that credit ratings have created inefficiencies in corporate credit and an opportunity for those willing to step down on the ratings spectrum.  Credit ratings tend to be backward looking algorithms that favor the size and longevity of a business.  The reality is that we are lending money to companies today and care about the future.  As such, historical ratings are interesting, but we believe not particularly relevant.  Think of equities: how many investors consider issuer/credit ratings for a company when they buy its stock?  If you are buying the most junior piece of the capital structure and don’t consider them, then why is so much emphasis placed on ratings for bond investors?

What I have seen in 30 years is that many investors continue to avoid bonds and loans rated below BBB (the dividing line between investment grade and non-investment grade) which is what creates the first structural inefficiency for the high yield market and can allow us to generate potential alpha.  What is mind numbing to me is that we have now gone through two “nuclear winters” (2002 and 2008) and the absurdity of credit ratings were at the core of both.  Do you remember what the ratings for Worldcom and Enron were just before they filed for bankruptcy and set the world on fire?  Investment grade!  How about the 2008 meltdown?  Weren’t Moody’s and Standard and Poor’s at the center of the flame with their AAA ratings on sub-prime Collateralized Debt Obligations (CDOs)?  It was so bad that government intervention and even legislation was pursued to remove credit ratings for bank and insurance determined capital ratios.  It never happened and all just quietly died.  Yet some investors continue to invest by and are beholden to this ratings process, which we view as limiting and potentially misguided.

Once investors migrate below investment grade, there is a further bi-furcation in high yield, as many players pitch what we like to call the “cream of the crap” story.  In essence, they will buy only BB rated securities.  Again, an investment process that is being dictated by rating agency black boxes.  We would argue that a portfolio of BB securities today could quite possibly be the worst of both worlds: you are still exposed to credit risk yet generate minimal yield.  Additionally, many BB securities trade like investment grade, meaning they are often very sensitive to changes in interest rates and may have much longer durations given their lower yields.

No diatribe on ratings would be complete without a little chat about investment grade corporate bond markets.  Investment grade is defined by Standard and Poor’s as BBB- and higher, while Moody’s defines it as Baa3 and higher.  I have been in the leveraged finance business for 30 years.  I cannot tell you the fundamental difference between a BB+ credit and a BBB- credit, yet one is “investment grade” and one is “junk.”  Who gave these firms the right to determine this and how is it determined?

What this all means is that we see continued pricing inefficiencies in single B and CCC credits as most investors avoid them given their perceived “risk.” For a much more detailed discussion on this, please see our piece “The New Case for High Yield.”


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Upcoming Events

As a reminder, Ron Heller, CEO of Peritus, will be a guest on Fox Business Network’s “After the Bell” on Tuesday, July 29th at 4pm ET.  Ron will also be featured on the ETF Store Show on Tuesday, July 29th at 9am CT.

Posted in news

Upcoming TV Appearance

Ron Heller, CEO of Peritus, will be a guest on Fox Business Network’s “After the Bell” on Tuesday, July 29th at 4pm ET.

Posted in news

Expanding the Opportunity Set for Income Generation

High Yield investors should understand the difference between an index-based product and its yield generation characteristics and portfolio composition based on the underlying index, versus some of the expanded opportunities available to active managers.  For instance in the high yield bond and bank loan space, we see index-based, passive products that are largely high yield bonds or largely floating rate bank loans, not a blend of each.

At Peritus, in addition to our core high yield bond holdings in our portfolios, we have the flexibility to capitalize on opportunities in dividend paying equities and floating rate loans.  We see this as an advantage as it allows us to invest up and down a company’s capital structure in terms of the security that we see the best from a risk/return perspective.  Additionally, this dramatically increases our investment universe and has a secondary benefit of reducing the portfolio’s duration.

We have two very specific focuses with our equity investments.  The first is related to thematic investing.  Though our themes will continue to evolve and change, the equity component in our portfolio is there to help execute on what we call “price to conviction.”   This means that we may have a very high degree of conviction on our particular theme and, in some cases, want to execute on this concept with the highest rate of return security available, which could be a dividend paying equity.

In today’s environment, this involves our energy theme.  We are looking to take advantage of what we feel are sustained high prices for oil and natural gas.  Companies operating in the Western Canadian Sedimentary Basin have much different (sustainable) production profiles than many in the shale basins in the US.  Several things are important to note: because Canada has a very nascent high yield market, companies often need the equity market to raise capital.  As such, many of these companies may pay out significant yields to attract investors and treat their dividends like interest payments.  They recognize that their dividend payments are sacrosanct and will adjust capital expenditures rather than cut their dividends.  And given the lack of substantial debt, we see the enterprise value through the equity as attractive in certain cases.

The second specific equity focus involves seeking to take advantage of the recent wave of refinancings for high yield companies.  We have stated that we are capital structure agnostic.  In this case, we have seen a number of companies refinance their bonds some 3.00% cheaper, or even more.  The interest savings flows down the capital structure, with additional cash flow generation to the benefit of the equity.  So the dividend is further enhanced/protected by this interest savings and in some cases our determination is the equity becomes the best risk/return part of the capital structure.

On the loan side, we see the biggest benefit being that there are companies that issue only loans and not bonds.  In some cases, these loans offer what we see as very attractive yield and by having the flexibility to include both bonds and loans, we are able to take advantage of these opportunities; rather than just being limited to those bond-issuing companies.  Furthermore, as we noted above, because of the floating rate nature, where-by rates can reset every three months, this can have a secondary benefit of reducing the portfolio’s duration.

We see that having this sort of flexibility on both the loan and equity side, above and beyond our core high yield bond holdings, as allowing us to expand the opportunity set for yield-bearing securities, giving us more flexibility in a given market cycle and environment, and allowing us to work to maximize alpha.

Posted in Peritus

Peritus in the News

Ron Heller, CEO of Peritus, was interviewed in the article, “Why junk-bond ETFs could drop in the next 1 to 3 months,” by Ben Eisen of MarketWatch, July 23, 2014.

Posted in news

Recent High Yield Dynamics

We have seen various market dynamics impact the high yield bond market and some selling pressure ensue over the past couple weeks; however, at the end of the day, we do not see that the opportunity in the high yield market has evaporated or that investors should run for the exits—if anything, lower prices can present a buying opportunity.  As an active manager, we have the ability to sell securities that have appreciated in value and/or sit at large premiums, and buy securities that have fallen in price during this widening; passive, index-based products are limited in their ability to do this.

In terms of some of the market impacts on high yield over the past couple weeks, one issue raised was Fed Chair Yellen recently expressing concerns on the valuations in the high yield market.  Of note, she also commented on over-valuations in biotech and social media stocks.  It seems a bit odd the Yellen is giving us investment advice, though nothing surprises us coming out of DC these days. I thought the Fed’s “statutory mandate” was “maximum employment, stable prices, and moderate long-term interest rates,” and then “explaining its monetary policy decisions to the public as clearly as possible”1?   We also saw James Bullard, President of the St. Louis Fed (though a non-voting member of the Fed), commenting that the Fed may need to raise rates more quickly than some have expected as the unemployment rate falls, inflation picks up, and macroeconomic conditions improve.

We think that investors need to keep these comments in perspective.  Yes, the high yield market has seen a large run up over the past several years and yields are low relative to history, but that is because interest rates have been at or near all-time lows for years (the Fed’s doing), pressuring yields in all fixed income securities as investors search for places to generate returns.  However, comparatively, we believe the high yield market, outside of the large flow names widely held by the index-based products, still looks very attractive.  Additionally we sit at a spread-to-worst level (the spread or yield-to-worst advantage over the yield on a comparable maturity risk free security/Treasury) of 428bps today, which is well over the all-time lows on spreads of 271bps, set in 2007 according to the Credit Suisse High Yield Index.2 And of note, this index has also spent nearly one-fifth of time at spreads sub-400bps over the past nearly three decades3 (see our blog “A Perspective on High Yield Spreads”).  So from a valuation perspective we do not see the high yield market as extreme, especially in the context of what is expected to be a low default environment (well below historical averages) for the next couple years.4

Additionally, we ultimately don’t see that the economic conditions are supportive of higher rates in the near to medium-term.  Data is open to interpretation, but the most recent data doesn’t seem to be indicating the strong Q2 recovery many in the stock market had hoped.  For instance, we’ve seen some disappointing retail sales of late and the housing market is showing some signs of cracks (weak housing starts).  Furthermore, yes, we are seeing the unemployment situation improve, but underneath the recently reported number is the reality that the job creation is coming from part time, low-wage work. There is still a large portion of working age people that are under-employed or that have given up looking for work all-together.

Above and beyond this, we see a long-term drag on rates coming from demographics, as the demand for fixed income products heat up (see our piece “Of Elephants and Rates”).  If anything, if you look at rates, those actually buying and selling bonds don’t seem to be getting the memo that rates will be rising soon, as the 10-year now sits at the lowest level that we have seen over the last 13 months.5  For evidence of this demand in Treasuries, look to the bid-to-cover ratio on all notes and bonds sold so far in 2014, which is over 3.0.  This means there was three times the demand as compared to issuance.  Additionally, keep in mind, just because the short-end of the curve might rise, that doesn’t necessarily mean the medium and longer end that corporate debt is more sensitive to will rise.  Ultimately these yields are determined by supply/demand, not necessarily Fed policy.

There has been a step back in the high yield market over the past couple weeks, nearly a 50 bps of spread-to-worst widening on the Band of America High Yield Index.6  We view that as healthy—no market should always, indiscriminately be going straight up.  We don’t believe that anything has fundamentally changed for this space or for the underlying companies, and we have even continued to see a well-functioning new issue market for high yield despite some of the pressure in the secondary high yield space.  While there could always be a surprise, we do not see any systemic shocks on the horizon.  There are certain areas that are of concern (such as the massive issuance of CLOs so far this year) but these areas are small and well contained.  So as we look at the current market, we would view these lower secondary prices for high yield bonds as a potential buying opportunity for secondary market players who are able to take advantage of them.

1 Source www.federalreserve.gov.
2 Current spread levels as of 7/17/14, based on the Credit Suisse High Yield Index, The Credit Suisse High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market.
3 Data sourced from Credit Suisse, as of 5/31/14.  Historical spread data covers the period from 1/31/1986 to 5/31/2014.  The Credit Suisse High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market.
4 For specific default projections sourced from J.P. Morgan, see our blog http://www.peritusasset.com/2014/06/a-perspective-on-high-yield-spreads/.
5 Current rate as of 7/17/14, based on the 10-year Constant Maturity Rate provided by the Federal Reserve.
6 Data sourced from Bloomberg, based on spread level of 353 as of 6/23/14 versus 399 as of 7/21/14 on the Bank of America High Yield index.  The Bank of America Merrill Lynch High Yield Index monitors the performance of below investment grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market.
Posted in Peritus

Peritus in the News

Peritus was mentioned in the following articles:

  • “Actively Managed ETFs Show Continued Growth,” by ETF Trends, July 16, 2014.
  • “Projecting Bond Total Returns For Rising Rates,” by Brad Kenagy, July 15, 2014.
Posted in news

US Crude Exports Announcement

The recent announcement by the Department of Commerce Bureau of Industry and Security (BIS) regarding the approval of two applications to export limited quantities of field condensate, after undergoing minimal treatment by way of a stabilizer, is significant and should improve the profitability of the Eagle Ford region’s exploration and production (E&P) companies.

Condensates are a hydrocarbon associated with the production of oil and natural gas.  Because of its higher API gravity, a measure used to compare the relative densities of petroleum liquids, than medium or heavy crudes, condensates can be more easily converted into products such as gasoline for example. However, the drawback is that condensates have less energy content per barrel than medium and heavy crudes. These lighter crudes have accounted for a significant percentage of the surge in US crude production. According to a recent report by the EIA entitled, “U.S. Crude Oil Production Forecast—Analysis of Crude Type” published in May of this year, approximately 96% of the 1.8 million bbl/d growth in production between 2011 and 2013 consisted of these lighter crudes (specifically those  with API gravity of 40º or above).1

Condensates fall into two categories: field/lease condensate and plant condensate. Field condensate is condensate produced from oil wells and put through a field separator, where the liquids are separated from the gases such as methane. Plant condensate is produced from raw natural gas through a fractionating process or plant separator.

Until this week the export of plant condensate was legal, but field condensate was not. The challenge for E&Ps producing large volumes of field condensate is that most refineries are set up to handle a relatively narrow range of crudes, and are largely not able to process this product. Those that lack hydrotreater capacity for example can’t handle crudes above a certain sulphur content.  Likewise those refiners that that have invested in billions in infrastructure, such as crackers and cokers to handle heavy crudes, like those on the Gulf Coast, are not set up to handle lights or super light crudes.  The wave of super light crude out of the Eagle Ford, including these field condensates, has overwhelmed the existing refinery infrastructure. As a result, domestic condensates have traded at a discount at the Gulf Coast in comparison to other regions, such as Asia, or even Edmonton, Alberta for example, where condensates are in high demand as a diluent to enable the pipeline transport of bitumen from Alberta’s oil sands.

So prior to the approval of exporting field condensates, we were in essence left with a product for which there was only a marginal domestic market.  Producers were undergoing complicated processes to get around the arbitrary distinctions between plant and field condensate; however, the most recent announcement by the Department of Commerce should make the export of field condensate much simpler through the use of stabilizers. A stabilizer is the means by which an E&P prepares condensate to be transported by pipeline. This is the key part of the ruling by the Department of Commerce; it was a green light for exporting field condensate once undergoing this process.

All in all, it was a ruling that makes good sense.  Condensate is of limited use to the existing Gulf Coast refineries that are set up to handle heavier crudes. By enabling the export of these light hydrocarbons, producers will have the ability to access international markets and obtain higher realized prices, and markets that need this product will now have access to additional supply. This should alleviate some of the congestion in the North American midstream infrastructure and likely positively impact Light Louisiana Sweet prices that are currently competing for refining space on the Gulf Coast. The oil market is dynamic and ever evolving. Keeping abreast of new developments and their potential impact on current and potential holdings is a key link in the chain of Peritus’ active management strategy.

1 U.S. Energy Information Administration, “U.S Crude Oil Production Forecast—Analysis of Crude Types,” May 29, 2014, p. 2.
Posted in Peritus

The Opportunity in Unconventional Oil

Be it energy geopolitics or pipeline politicking, oil markets are clouded by noise that push prices up and down. In order to make long-term investments in the space the trick is to boil it down to the bare bones of the issue. Recently an article was published espousing that oil was headed to $75. It was an interesting notion but not one we would put much stock in for a variety of reasons, the most basic of which being supply.

Conventional production (a category that includes onshore and offshore crude oil, natural gas and condensates produced by way of traditional vertical drilling methods) around the globe is in decline. Unconventional production is the primary source of new production coming to market today. Those unconventional sources fall into three broad categories. Shale oil, oil sands and ultra deepwater. Offshore, ultra-deep is pretty self-explanatory: it’s deep and expensive. The onshore complications, though, seem to get glossed over or forgotten so let’s review them.

Shale oil extraction is accomplished by way of horizontal drilling and fracking the source rock (shale). In lay person terms it is basically this: you drill a hole a couple of miles deep then steer the drillbit 90º and drill sideways another couple of miles. As if that weren’t enough trouble to go through to get a return, now you remove the drill, case the well and set to the process of breaking up the rock in a series stages by way of perforations. Once the “micro fissures” are created, you have to keep them open and encourage the oil to flow, so water, sand and often a myriad of other chemicals are pumped into the cracks. As you can imagine this is not a cheap process. What makes it more challenging though is that the decline rates—how quickly the oil flowing from the well peters out—are very high (we estimate 80-90% in the first three years so). As a result, you have to keep drilling at a very high rate just to maintain production levels.

Canada’s oil sands are the other key source of unconventional production. They are located in Northern Alberta where temperatures in the winter can routinely reach -40º Fahrenheit and in the summer the bugs are so bad small children can be carried away. 20% of the oil from the oil sands is minable (those are the nasty pictures you always see when anyone mentions the oil sands, or tar sands as they are affectionately referred to). The other 80% is too deep to mine and are thus only producible by way of in-situ thermal production.1 The most common thermal production method is called Steam Assisted Gravity Drainage or SAGD.

SAGD entails drilling two horizontal wells one directly above the other, called well pairs. The top well pair, called the injector well, injects stream, heated by natural gas. The bottom well pair is called the producer well and brings the water and bitumen to the surface. Numerous well pairs are required per reservoir. The time from first stream to production can be anywhere from 18-24 months. Once heated sufficiently the bitumen, which has the consistency of a hockey puck at room temperature, turns into a viscous sludge that by way of gravity falls downwards to the producer well at the bottom. From there the producer well pumps the sludge to the surface were it is mixed with condensates/superlight oils to be transported to market. By our estimates, based on conversations with industry professionals, the costs associated with building one of these facilities is about $50,000 per flowing barrel. So that means if you want to build a 20,000 barrel per day facility you need a billion dollars and then wait two years for any type of return.

We’re not peak oil theorists, but realists. If oil were plentiful nobody would care about shale oil, oil sands or ultra deepwater plays. They would be considered marginal barrels in a well-supplied market and would never get produced due to the lower prices that would accompany such an environment. That however is not the world we live in, and looking forward these barrels are the primary sources of new production coming to market.

When one looks at where oil is headed common sense tells us that it won’t be below the cost plus a decent rate of return that is required to bring these sources of oil to market. Ultimately, as we rely more and more on this unconventional production, we see high oil prices as here to stay and investors need to invest accordingly.

But just where do you invest?  Are all of these oil producing regions making for attractive investments?  We argue no.  We believe that the Western Canadian Sedimentary Basin (Canadian oilsands) has a much different and more sustainable production profile than most shale basins in the US.  We do not see the shale “revolution” as anything of the sort; rather, current production and growth in this area is unsustainable.  The decline rates on these wells are extreme, meaning more and more holes will need to be punched to keep production flat.  A look at the U.S.-based crude growth numbers and expectations shows that the massive growth we have seen is expected to peter out over the next several years.2

Blog 7-15-14

Source: U.S. Energy Information Administration, data as of January 13, 2014.

With the easiest oil produced first, the marginal cost of a new barrel of production will likely continue to increase.  Above and beyond the rapid decline rates, we see other challenges to shale production, including that this is a water intensive process, yet we are seeing droughts in the Midwest and West, and legislation on the safety of fracking and the transportation of product is likely to get more severe.

Unconventional resources have become conventional.  The overall quality and access to some of these “new conventional” energy reserves is declining, increasing costs for producers and we expect to ultimately keep prices elevated.  We believe that investors should be long and strong this industry to take advantage of the sustained higher prices.  However, selectivity is warranted. Investors should avoid what we believe is the next CLEC-Telco disasters of 2002-03, which is the high yield market financing of many unsustainable business models known as shale/tight oil production.  Here we have seen incredible popularity, with deal after deal getting done, regardless of quality, and many done at very low yields, which we feel do not compensate investors for the risk of the lack of cash flow generation and sustainability of some of these businesses.

We also believe that investors should be cautious in Master Limited Partnership (“MLP”) investing.  Investors have been enticed by the juicy yields offered, but unfortunately many of them are not generating true distributable cash.  Worse yet, “cash available for distribution” is a metric that the company themselves calculate.  This is a situation of the fox guarding the hen house.  This metric is calculated by breaking up capital expenditures into “maintenance” and “growth.”  So the more the company lumps their capital expenditures into the “growth” bucket, the more fictional cash flow they have available.  Some of the companies we have looked at state that 80% of their capital expenditures are “growth,” yet they aren’t growing.  For investors this then is a return of capital not a return on capital and we believe is unsustainable.

We have seen a recent pull back in the price of oil and believe it creates an opportunity to continue to invest in oil producers.  Our take remains that supply from US tight oil/shale is real but temporary and that many of the swing producers will continue to struggle to meet their production targets.  As examples, look to Libya, Iraq, Venezuela and Nigeria.  We continue to invest up and down the capital structures (loans, bonds and yield equities) of what we view are very sustainable producers to find what we see as the optimal risk/return characteristics.

1 Source: Wikipedia, Athabasca oil sands, http://en.m.wikipedia.org/wiki/Athabasca_oil_sands.
2 Source: U.S. Energy Information Administration, data as of January 13, 2014.


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